How To Outperform The Barclays Agg

November 18, 2016

ETF.com: Shorter term, if we see higher interest rates beginning in December, possible tax cuts and a pickup in inflation, as many predict, should we expect investor demand to shift out of long-dated Treasurys and into TIPS and shorter-term debt?

O’Neil: The Federal Reserve will increase the fund rates rate by 25 basis points in December. But if you look at market expectations for 2017 and 2018, the market today is only anticipating three rate increases over that next two-year period. That’s very modest.

More of the reaction we’ve seen from the market is in the 10- and 30-year portion of the curve. Its term premium is rising because of the uncertainty. But, yes, we like TIPS a lot relative to nominal Treasurys; but we've liked them for all of 2016.

The breakevens on TIPS were below 1.5% at the beginning of this year. We felt that was unsustainable. We didn't know when inflation might actually come back. We felt that pressure was building in the pipeline, especially on the wage side.

We were confident we were going to see inflation at some point in time, but it's come fairly quickly in the last two weeks. You've seen a fairly significant increase in Treasury inflation-protected breakevens over that time period. We own nominal Treasurys in the portfolio, but we think TIPS are also something you should have in your portfolio.

ETF.com: FBND is one of four actively managed total return bond ETFs on the market today. And so far in 2016, it’s outperformed its peers by at least 2 percentage points. What's behind this outperformance?

O'Neil: There are really two factors. On one hand, we feel that the Federal Reserve is no longer in the QE business. At the same time, Treasury yields remain quite low, and agency mortgage-backed security spreads remain quite tight relative to history.

Both sectors will revert to historical norms over the coming years. That could take two or three years. So we feel both of those government guaranteed sectors are not attractive relative to other opportunities in the marketplace.

In underweighting those sectors, we also overweighted TIPS. Our TIPS position is about 6% in the fund. We also have a material overweight to credit. That credit is both in the investment-grade and in the noninvestment-grade areas. Both are attractive.

We also liked the commercial mortgage-backed securities market, the CMBS market and emerging markets. And we have a little bit in taxable munis.

We have a couple hundred investment professionals in our fixed-income group continually turning over rocks and coming up with great ideas across the entire spectrum of fixed income.

We've got hundreds of securities in the portfolio that we think are really attractive that will have similar risk profiles to that of the benchmark, but much better return profiles. And by having small overweights in all those different sectors, and picking good securities, we’ve seen material outperformance relative to the benchmark.

 

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